Whilst it may seem financially attractive for US citizens living in the UK to take advantage of UK based investments, it can often result in a painful financial outcome.
US citizens are required to file an annual Tax Return with the Internal Revenue Service (IRS) on a global basis. However, for US tax purposes the functional reporting currency is the US dollar and this then means US citizens living outside of the US are exposed to exchange rate fluctuations. In certain circumstances this may then give rise to US taxation on income that has not occurred in the host country currency.
This transpires in several ways. For example, if you are trading stock in UK sterling, for US tax reporting purposes, when you come to sell the stock you are required to report the acquisition and sales price in dollars, based on the exchange rate for both days. Quite often this leads to the creation of a dollar gain that exceeds the gain in sterling.
Other notable instances where the exchange rate issue takes effect, is where a US taxpayer sells a home in the UK that has a sterling-based mortgage secured against it. Not only can the sale of the house create an artificial dollar gain based on the applicable exchange rates at the date of purchase and sale, but the redemption of the mortgage can also create a dollar gain on its settlement. In these cases the IRS treat such a payment as a settlement of a loan.
And it’s not just exchange rates that can cause a problem. Venturing into certain UK tax efficient investments simply doesn’t work for US tax purposes, and any income not taxed in the UK that the investment generates, will be taxed in the US in the year earned reducing the value of the product.
The IRS is very keen for US taxpayers to report where their assets are sited, meaning that for certain investments, not only do you have potential tax to pay, but also onerous reporting procedures to follow when advising the IRS that you have them and where they are.
Without a doubt, the ownership of a common stocks and shares ISA is the least attractive of all investments for the US taxpayer. Commonly referred to as an “ISA wrapper account”, this is an account that may have any number of individual funds sat within it to form the overall product. Hence the concept of the “wrapper”.
So, what’s the problem? The IRS view each individual fund as being a standalone foreign entity, or so called PFIC (Passive Foreign Investment Corporation) which must be reported each year on IRS Form 8621, along with any activity that is also required to be potentially reported within the fund.
The cost to complete such complex forms by your Tax Advisor and the potential annual tax generated by the investment, can quickly negate any tax advantage or the value of the investment.
Whilst an investment into a Personal Pension Plan or SIPP can be tax efficient, it is dependent upon annual reporting being completed correctly. Failure to do so may result in the IRS seeking to tax any growth in the accumulated funds and apply harsh penalties for failing to report and file correctly.
To sum up, if you do proceed with such investments, be prepared. Allow for the requirement to file a more complex tax return, which inevitably will be more expensive to have prepared given the complexities of the required reporting; and that UK tax free investments may not perform as efficiently as hoped given the IRS treatment of such vehicles.
And finally, always remember the influence of exchange rates – sometimes it does work to your advantage, but more often than not there is the potential for a painful and unwelcome sting in the tail.